I Mean, Really, What is Risk Tolerance Anyway?

Since the dawn of time (well, that might be a tad exaggerative), financial advisors have been trying to devise ways to mathematically calculate and predict the very subjective and complex matter of their clients’ risk tolerance. 

Even the supposedly “objective” side of risk tolerance, also known as “risk capacity” (how much loss can a client withstand and still financially reach their goals), assumes an extremely narrow perspective of possibility, focusing solely on individually accumulated funds as the only method of reaching a goal. How would one calculate and include the potential opportunities the individual’s community of friends, family, or special interest groups might provide? Or the discovery of alternative methods for reaching their goal that don’t require the specified financial funds?  Ironically the calculation of risk capacity excludes the one thing that might actually INCREASE the individual’s risk capacity - the creative art of possibility thinking.

Ironically, the calculation of risk capacity excludes the one thing that might actually INCREASE the individual’s risk capacity - the creative art of possibility thinking. Click To Tweet

And, don’t even get me started on the problems with trying to calculate the “subjective” side of risk tolerance, or an individual’s “risk preference.”  Well, ok, I’m already riled up. Most risk tolerance questionnaires ask clients to assess or predict how they would react given various scenarios of market downturns. Although this can provide some useful information about their perspective while in a calm and safe space (they are aware these dire market scenarios are not actually occurring in the moment), their predictions are likely to be wildly inaccurate. The truth is, we can’t accurately predict how we will respond to unexpected or traumatic scenarios. When anxiety or fear strikes, our analytical brains shut down and fight, flight, fawn, or freeze responses override our bodies and brains. You and your clients will act in unpredictable and possibly illogical ways.

Rather than taking a qualitative data gathering type approach to understanding this information, our profession has tried to squeeze these deeply human complexities into a very black and white, quantitative data gathering method.

Let’s consider for a moment, how these reactions to unexpected events were formed and how they manifest in our lives. A part of how we respond is based on personality traits we were born with (think temperament and perceptiveness), but a large portion is based on learned experience (what has successfully kept us safe in dangerous situations). Over time, our “trauma responses” become very quick, automatic, and subconscious. This means, your clients may not consciously recognize, without mindful reflection, how they’ve responded to challenges throughout their own lives.

At Money Quotient, we believe a far more accurate assessment of your clients’ subjective risk tolerance can come from guiding them in exploring and reflecting on unexpected or difficult challenges they have had to navigate in the past. Besides financial loss, have they managed other types of losses in the past? Have there been various types of obstacles that have thrown them off track? How did they respond to those incidents? What skills, abilities, and relationships helped them cope or make it through? 

Because these behaviors have been largely subconscious for most of their lives, they will likely not have well formulated thoughts to share immediately. A well-constructed practical process with effective questions can assist in guiding the clients to insight and awareness.

Becoming aware of these instinctual reactions will not only help you to more accurately align your financial strategies with your clients’ risk tolerance, but it will also be the first step in addressing their own problematic behaviors. Changing these deeply engrained reactions requires time, patience, practice, and another blog post!

- Amy N. Mullen, CFP®